We've seen that the financial manager acts in the best interests of the stockholders by taking actions that increase the value of the stock. However, in large corporations ownership can be spread over a huge number of stockholders. This dispersion of ownership arguably means that management effectively controls the firm. In this case, will management necessarily act in the best interests of the stockholders? Put another way, might not management pursue its own goals at the stockholders' expense? In the following pages, we briefly consider some of the arguments relating to this question.

Agency Relationships

The relationship between stockholders and management is called an agency relationship. Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his/her interests. For example, you might hire someone (an agent) to sell a car that you own while you are away at school. In all such relationships, there is a possibility of a conflict of interest between the principal and the agent. Such a conflict is called an agency problem.

Suppose you hire someone to sell your car and you agree to pay that person a flat fee when he/she sells the car. The agent's incentive in this case is to make the sale, not necessarily to get you the best price. If you offer a commission of, say, 10 percent of the sales price instead of a flat fee, then this problem might not exist. This example illustrates that the way in which an agent is compensated is one factor that affects agency problems.

Management Goals

To see how management and stockholder interests might differ, imagine that the firm is considering a new investment. The new investment is expected to favorably impact the share value, but it is also a relatively risky venture. The owners of the firm will wish to take the investment (because the stock value will rise), but management may not because there is the possibility that things will turn out badly and management jobs will be lost. If management does not take the investment, then the stockholders may lose a valuable opportunity. This is one example of an agency cost.

More generally, the term agency costs refers to the costs of the conflict of interest between stockholders and management. These costs can be indirect or direct. An indirect agency cost is a lost opportunity, such as the one we have just described.

Direct agency costs come in two forms. The first type is a corporate expenditure that benefits management but costs the stockholders. Perhaps the purchase of a luxurious and unneeded corporate jet would fall under this heading. The second type of direct agency cost is an expense that arises from the need to monitor management actions. Paying outside auditors to assess the accuracy of financial statement information could be one example.

It is sometimes argued that, left to themselves, managers would tend to maximize the amount of resources over which they have control or, more generally, corporate power or wealth. This goal could lead to an overemphasis on corporate size or growth. For example, cases in which management is accused of overpaying to buy up another company just to increase the size of the business or to demonstrate corporate power are not uncommon. Obviously, if overpayment does take place, such a purchase does not benefit the stockholders of the purchasing company.

Our discussion indicates that management may tend to overemphasize organizational survival to protect job security. Also, management may dislike outside interference, so independence and corporate self-sufficiency may be important goals.

Do Managers Act in the Stockholders' Interests?

Whether managers will, in fact, act in the best interests of stockholders depends on two factors. First, how closely are management goals aligned with stockholder goals? This question relates, at least in part, to the way managers are compensated. Second, can management be replaced if they do not pursue stockholder goals? This issue relates to control of the firm. As we will discuss, there are a number of reasons to think that, even in the largest firms, management has a significant incentive to act in the interests of stockholders.

MANAGERIAL COMPENSATION   Management will frequently have a significant economic incentive to increase share value for two reasons. First, managerial compensation, particularly at the top, is usually tied to financial performance in general and oftentimes to share value in particular. For example, managers are frequently given the option to buy stock at a bargain price. The more the stock is worth, the more valuable is this option. In fact, options are often used to motivate employees of all types, not just top management.

The second incentive managers have relates to job prospects. Better performers within the firm will tend to get promoted. More generally, those managers who are successful in pursuing stockholder goals will be in greater demand in the labor market and thus command higher salaries.

In fact, managers who are successful in pursuing stockholder goals can reap enormous rewards. For example, one of America's best paid executives in 2004 was Rueben Mark, the CEO of Colgate-Palmolive for the past 20 years; according to Forbes magazine, he made $148 million in that year. By way of comparison, Mark made less than Mel Gibson and Oprah Winfrey ($210 million each) but more than Tiger Woods ($80 million). Over the period 2000—2004, Oracle CEO Larry Ellison was the highest paid executive, earning about $836 million. Dell CEO Michael Dell earned slightly less over the same period, only $526 million.

CONTROL OF THE FIRM   Control of the firm ultimately rests with stockholders. They elect the board of directors, who, in turn, hire and fire management. The fact that stockholders control the corporation was made abundantly clear by Carly Fiorina's experience at HP, which we described to open the chapter. Even though she had reorganized the corporation, there came a time when shareholders, through their elected directors, decided that HP would be better off without her, so out she went.

An important mechanism by which unhappy stockholders can act to replace existing management is called a proxy fight. A proxy is the authority to vote someone else's stock. A proxy fight develops when a group solicits proxies in order to replace the existing board, and thereby replace existing management. For example, the proposed merger between HP and Compaq, which we mentioned in our chapter opener, triggered one of the most widely followed, bitterly contested, and expensive proxy fights in history, with an estimated price tag of well over $100 million.

Another way that management can be replaced is by takeover. Those firms that are poorly managed are more attractive as acquisitions than well-managed firms because a greater profit potential exists. Thus, avoiding a takeover by another firm gives management another incentive to act in the stockholders' interests. For example, in 2004, Comcast, the cable television giant, announced a surprise bid to buy Disney at a time when Disney's management was under close scrutiny for its performance. Not too surprisingly, Disney's management strongly opposed being acquired, and Comcast ultimately decided to withdraw, in part because of improvements in Disney's financial performance.

CONCLUSION   The available theory and evidence are consistent with the view that stockholders control the firm and that stockholder wealth maximization is the relevant goal of the corporation. Even so, there will undoubtedly be times when management goals are pursued at the expense of the stockholders, at least temporarily.

Stakeholders

Our discussion thus far implies that management and stockholders are the only parties with an interest in the firm's decisions. This is an oversimplification, of course. Employees, customers, suppliers, and even the government all have a financial interest in the firm.

Taken together, these various groups are called stakeholders in the firm. In general, a stakeholder is someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm. Such groups will also attempt to exert control over the firm, perhaps to the detriment of the owners.